How to Invest in Opportunity Zones

Introduction

Writing about his motivation to become a real estate investor, Gary Keller noted:

“One of the things I learned was the simple difference between financial riches and financial wealth. Being rich is about having money. You can have a job and be very rich. The problem with this is that the money stops coming to you when you stop working for it. Financial wealth, by contrast, is about owning assets, such as businesses or real estate, that generate money for you.” (Gary Keller, The Millionaire Real Estate Investor, McGraw-Hill Education).

Real Estate is one of the best asset classes for growing wealth over time.  There are many reasons for this:

• Scarcity: there is a limited supply of property.
• Appreciation: the value of an investment property can increase over time.
• Inflation Protection: cash flows from properties normally increase alongside inflation.
• Income-Producing: many properties generate income while also growing in value.

All the above considered, the icing on the cake for investors in the United States is the tax benefits associated with real estate. Most real estate investors are familiar with tax incentives such as depreciation schedules, exchanges, and capital gains deferrals. The newest (and possibly most attractive) tax benefit for real estate investors is the Qualified Opportunity Zone program.

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What is a Qualified Opportunity Zone?

The Qualified Opportunity Zone (QOZ) program was created by the Tax Cuts and Jobs Act passed by Congress in 2017.  The program is designed to encourage investment into low-income or economically distressed communities across America by offering tax incentives to investors. The governments in each state designated specific geographical areas for qualification, which were then certified by the U.S. Treasury.  With a quick Google search, you can find Opportunity Zone maps for your region or state (for a map of all Opportunity Zones in the U.S., click here).

Two other important terms are Qualified Opportunity Funds (QOF) and Qualified Opportunity Zone Businesses (QOZ Business). We’ll talk about how these fit into an investment in a bit, but at a high level, a QOF is the entity (usually an LLC or partnership) that makes investments in QOZ properties. A QOZ Business is exactly what it sounds like – a business that operates in a QOZ. These different terms can be confusing, but they’re important to understand the technical aspects of how opportunity zone investments are structured. As always, if you invest in a QOZ project, have an experienced CPA and Attorney review the technicalities.

One more note on definitions – you must improve a property to qualify for the QOZ tax incentives. This is called the Substantial Improvement Test.  The IRS has left the definition of this fairly vague, but the rule of thumb is that investors must double their cost basis during any 30-month period in which they hold the property. Scott Meyer, managing principal and chief investment officer of Kairos Real Estate Advisors, explained that “an investor cannot benefit from the tax incentives if their plan is to buy a stabilized asset, throw a new coat of paint on it and call it a day.” Because of this rule, real estate investments in Opportunity Zones involve development or major value-add projects.

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What are the tax benefits of investing in a Qualified Opportunity Zone?

There are three main tax benefits: deferral, reduction, and elimination.

• Deferral: An investor with a capital gains event (defined below) can defer capital gains recognition from the original investment until December 31, 2026.  This allows for more capital to be deployed into the Opportunity Zone project.
• Reduction: The amount of capital gain from the original investment is reduced by 10 percent after the investor holds the property for five years. Since the deadline for capital gains recognition is December 31, 2026, the property would need to be purchased by the end of 2021 in order to take advantage of this benefit. There was a 15 percent reduction for property held for seven years, but unless the deadline is extended, that mark passed in 2019.
• Elimination: If you hold the property for more than ten years, your basis steps up to fair market value on the date you sell or exchange it. This eliminates any capital gains recognition after the ten-year hold period as long as you exit before December 31, 2047.  When you consider the appreciation of real estate mentioned earlier, this particular benefit offers the most value to those with the goal of producing long-term wealth.

For more information on the tax benefits, go here.

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How to invest in a Qualified Opportunity Zone?

Once the investor receives capital gains from the sale of any type of asset (stocks, mutual funds, real estate, businesses, etc.), they have a window of 180 days to invest some or all of the gain into a QOF.  As mentioned above, the QOF is simply the vehicle for investing into a QOZ. The QOF must deploy at least 90% of its capital into QOZ property (either real estate or a QOZ Business).

The most common structure is to set up a QOZ Business that the QOF will own. Besides supporting a cleaner accounting system and tax structure, this unlocks additional benefits: QOZ businesses are only required to hold 70% of their assets in a QOZ. So investors in the fund can take advantage of the tax benefits with additional investments outside of QOZ property. This graph from Shartsis Friese Law illustrates the setup:

As you can imagine, setting up the legal structure, accounting qualifications, and reporting systems are costly and time consuming. Because of this, many investors choose to invest in a QOF that is managed by a professional 3rd party. This is usually an experienced real estate investor or private equity company who organizes and manages the investment for a fee and promote (industry term for a performance-based equity bonus). The investor still receives all of the tax benefits, but receives a passive income without the hassle of setting up and managing the business.

Two more items to consider when investing in QOZs:

• Many investors are familiar with deferred capital gains through the like-kind exchange rules (commonly known as 1031 exchanges). While the QOZ rules seem to provide better incentives, you’re limited to the State-designated areas and the holding period requirements. There are situations where a 1031 exchange may be a better fit for your project.
• You can invest capital unrelated to capital gains into a QOF, but you would not be able to take advantage of the deferral or reduction tax incentives mentioned above.

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Conclusion

Generally, real estate benefits investors who have the desire and ability to play the long game. The QOZ incentives further emphasize the need to plan on a long-term investment. If that time preference makes sense, a QOZ investment is an excellent vehicle for increasing wealth over time while benefiting low-income and economically distressed communities across the country.